Question

Lane Industries is considering three independent projects, each of which requires a $2.4 million investment. The estimated internal rate of return (IRR) and cost of capital for these projects are presented here: Project H (high risk): Cost of capital = 14% IRR = 16% Project M (medium risk): Cost of capital = 9% IRR = 7% Project L (low risk): Cost of capital = 7% IRR = 8% Note that the projects' costs of capital vary because the projects have different levels of risk. The company's optimal capital structure calls for 40% debt and 60% common equity, and it expects to have net income of $3,400,000. If Lane establishes its dividends from the residual dividend model, what will be its payout ratio? Round your answer to two decimal places.

Answer 1

Only those projects will be accepted whose IRR is greater than the cost of capital

i.e. Projects H and L

Amount required for investment = 2.4 million*2 = $4.8 million

To be funded through Equity = 4,800,000*60% = $2,880,000

Under Residual model, income remaining after meeting expenditure for all profitable projects is distributed as dividend

Hence, amount of dividend = 3,400,000 – 2,880,000 = $520,000

Hence, payout ratio = Dividend/Income

= 520,000/3,400,000

= 15.29%